Planners have long recommended that clients save and invest, even while they have a mortgage, since the long-term return on equities generally exceeds the interest rate on a mortgage. Yet in reality, investors don’t simply choose to invest in equities because the return is higher than a fixed alternative; instead, investors demand an equity risk premium over and above the risk-free rate to make equity investing worthwhile. For the traditional investor, the equity risk premium has represented the excess return of stocks over long-term government bonds. Yet for the mortgage borrower, the available "risk-free return" isn’t just a government bond, but to prepay the mortgage and eliminate the interest cost! As a result, while the investor looks for an equity risk premium over government bonds paying 2%, the mortgage borrower actually shouldn’t invest in stocks unless there’s an expectation to earn an equity risk premium over a mortgage interest rate that might be 4% to 5%! Consequently, clients should prepay their mortgages unless they expect a full 9%-10%+ return on equities in the current environment that sufficiently rewards them for the risk!
The inspiration for today’s blog post is a recent conversation I had with another planner about the risks of keeping a mortgage while saving/investing into a portfolio, versus just paying down the mortgage. As I’ve written in the past, saving into a portfolio instead of prepaying a mortgage is the equivalent of buying stocks with leverage, which as we know from margin accounts can be quite risky. Yet as my fellow planner maintained, as long as stocks have an expected return that’s higher than the cost of borrowing… "why not?"
The answer, I stated, is that it’s not sufficient to just get a higher return from stocks than it costs to borrow on the mortgage. The borrowing cost of the mortgage – or rather, the effective return that you get by repaying the mortgage and eliminating the associated interest cost – is a guaranteed, risk-free return. Investing in stocks, on the other hand, is risky. No investor would prudently pick a highly risky return just because it’s barely higher than a risk-free alternative!
In fact, as we see from the past century of investing, stocks command an ‘equity risk premium’ to compensate investors for the dangers of owning stocks relative to a risk-free alternative. While Treasury Bills have only returned about 3% over the past century – essentially just keeping pace with inflation and generating a real return of 0% – intermediate to long-term government bonds have generated a return of about 5% (real return of 2%), while stocks have produced a long-term return of about 10% (real return of about 7%). This means long-term investors have demanded an equity risk premium of about 5%, the excess of stock returns over longer-term-but-risk-free government bonds that can be held to maturity. (Editor’s note: There is some debate about exactly how big the equity risk premium is, with some advocating amounts slightly higher or lower than 5%, but we’ll use 5% relative to Treasury Bonds as a baseline.)
Notably, if it was merely sufficient for stocks to "just" outperform bonds by any amount, we wouldn’t see a whopping 5% gap between the return of stocks and the return of long-term risk-free govnerment bonds over the long run. Stock prices would have been bid up to the point where they would just barely outperform bonds, and persist at that return for the indefinite future. But in reality, that’s not the case. Stocks are risky, and can go through extended periods of time where they underperform bonds. Consequently, investors only buy at a price that implicitly meets their demand for a higher return – in the form of an equity risk premium over the risk-free rate – to be compensated for their investment risk.
So how does this relate to paying down a mortgage versus investing in stocks? Like the investor, the borrower would choose to invest in stocks as long as equities were anticipated to produce the desired total return – including an appropriate risk premium – over the risk-free rate. However, while the risk-free rate is the return on government bonds for the investor, the risk-free rate for the borrower is the interest rate on the mortgage that could simply be repaid instead of investing in stocks!
Which means in practical terms, the mortgage borrower shouldn’t avoid pre-paying the mortgage and investing in stocks simply because equities are expected to earn a higher return. If the borrower is going to be compensated for the risk of the investment, the borrower shouldn’t direct money towards stocks unless expected to earn the mortgage interest rate plus a 5% risk premium.
This situation creates an interesting dichotomy in today’s environment. In a world where the 10-year bond yields about 2%, then in theory an investor earning 7% in stocks is reasonably compensated for the risk. However, only the Federal government borrows at 2%; the typical homeowner likely has a 4% to 5% mortgage interest rate. In turn, this means that it’s only appropriate to direct money towards stocks if there’s a reasonable expectation that stocks will earn 9% to 10% over the time horizon… even though some are forecasting a 10-year equity return as low as 4%!
Of course, any particular investor will determine his/her own expected return for stocks (and in theory could select a different equity risk premium). But the fact remains that if the borrower merely expects that stocks will generate a better return than the mortgage interest rate, but not more than 5% better (or some other risk premium), the borrower is not being sufficiently compensated for the risk of the endeavor. Alternatively, as many planners have been reducing their own forecasts for the return of equities in the coming years, to the point where equities are no longer expected to earn 9%+ returns for the next decade, this suggests that planners should be directing clients to prepay/pay down mortgages for the risk-free return, as the equity returns no longer justify an investment due to the insufficient equity risk premium they offer the borrower. And this is true even if stocks are a reasonable investment relative to government bonds, because there remains a disparity between the risk-free government bond rate for the investor, and the risk-free mortgage interest rate for the borrower.
So what do you think? Is it reasonable to expect that stocks must significantly out-earn the borrowing rate in the form of an equity risk premium to justify holding onto a portfolio instead of prepaying a mortgage? Do you believe that equities will earn enough to make the investment worthwhile for a mortgage borrower? Should clients who don’t feel the current outlook for stocks carries a sufficient risk premium over their loan interest rate shift to paying down the mortgage instead?
(Editor’s Note: This article was featured in the Carnival of Personal Finance: The Color Wheel Edition on the blog Money Talks.)